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Model Comparison with Sharpe Ratios

Published online by Cambridge University Press:  09 August 2019

Francisco Barillas ,
Raymond Kan ,
Cesare Robotti  and
Jay Shanken Open the ORCID record for Jay Shanken [Opens in a new window]
Francisco Barillas
Affiliation:
Barillas, [email protected], University of New South Wales School of Banking and Finance
Raymond Kan
Affiliation:
Kan, [email protected], University of Toronto Rotman School of Management
Cesare Robotti
Affiliation:
Robotti, [email protected], University of Warwick Business School
Jay Shanken*
Affiliation:
Shanken, [email protected], Emory University Goizueta Business School and National Bureau of Economic Research (NBER)
*
Shanken (corresponding author), [email protected]
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Abstract

We show how to conduct asymptotically valid tests of model comparison when the extent of model mispricing is gauged by the squared Sharpe ratio improvement measure. This is equivalent to ranking models on their maximum Sharpe ratios, effectively extending the Gibbons, Ross, and Shanken (1989) test to accommodate the comparison of nonnested models. Mimicking portfolios can be substituted for any nontraded model factors, and estimation error in the portfolio weights is taken into account in the statistical inference. A variant of the Fama and French (2018) 6-factor model, with a monthly updated version of the usual value spread, emerges as the dominant model.

Type
Research Article
Information
Journal of Financial and Quantitative Analysis , Volume 55 , Issue 6 , September 2020 , pp. 1840 - 1874
Copyright
Copyright © Michael G. Foster School of Business, University of Washington 2019

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Footnotes

We thank Hendrik Bessembinder (the editor), Wayne Ferson, Seth Pruitt (the referee), Chen Xue, and participants at the 2018 SoFiE Conference, the 2018 Western Finance Association Meetings, the 2018 China International Conference in Finance, the 2018 Institute of Mathematical Statistics (IMS) Asia Pacific Rim Meeting, and the 2017 workshop “New Methods for the Empirical Analysis of Financial Markets” in Comillas, Spain, for helpful comments and suggestions. Finally, we thank Kenneth French for providing us with the data on several factor portfolios used in this article.

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